Less than ideal: possible licensing approaches for Tracer DAO

Hello Tracer Community,

Greetings from the sidelines! I first stumbled across Tracer through the AFR article last month, and have gone deep down the rabbit hole since then. While history is littered with the number of startups that have failed to deliver on their promise to ‘democratise finance’, I feel like Tracer DAO has a real shot at unlocking a new range of hedging tools to meet the risks and social issues faced by retail investors the traditional market has so far failed to provide.

I’d like to offer as a topic for further conversation the issue of licensing: fitting crypto-assets into our existing regulatory framework (I’m writing from a Australian perspective, but you can extrapolate more broadly) is something of a square-peg-in-a-round hole exercise, and will require legislative action to remedy. Fortunately, this process is already underway with the Senate inquiries into fintech and crypto-assets, but waiting upon government to take action within a commercial timeframe should never be the only option. At the very least, Tracer DAO should consider as an alternative the possibility of applying for an operating license under the current financial regulatory regime.

A number of benefits should flow from this exercise: a best-case scenario would see a clear pathway for Tracer DAO to acquire a license and its associated benefits, including enhanced legitimacy in the eyes of the regulators and the broader public. From this community’s public statements so far on the topic, I understand this to be a priority for Tracer DAO.

However, even if it is concluded that a license is not obtainable under current circumstances, Tracer DAO will have sharpened its thinking on what the future licensing regime for crypto-assets should look like. A licensing regime that is not fit for purpose, or that fails to accommodate the diversity of functions crypto-assets can be put to use towards would be a poor outcome for Tracer DAO: the fruits of this discussion will hopefully equip the community to diminish that outcome from eventuating.

So what would licensing for Tracer DAO look like under current circumstances? I’d begin with looking at licence classes currently available to conventional financial services providers, and aligning Tracer DAO’s functions under those licensing classes. I‘ve left the possibility of obtaining a credit licence off this list because I think it’s probably too far a bow to draw at this stage, but can see how applying for an ACL might make sense in the future.

That being so, I’d consider:

Financial Services Licence (FSL)

This licence would cover the provision of financial services, and of financial products (itself defined to be a financial service).

At first glance, Tracer DAO’s capacity to provide for financial products built upon smart contracts issued through its factory function would seem to fall squarely within the range of activities a FSL purports to cover. On reflection however, a better view would be to consider Tracer’s factory function to be one step removed from the provision of financial products. An accurate analogy would be that of a trade association developing template contracts for their members to use throughout the course of their business: to use a real life example, ISDA maintains the standard form contracts market participants base derivatives off, but responsibility for product (particularly when things go off the rails) sits the institutional bank or swap dealer who issues the product based off ISDA documentation.

There are a number of reasons why Tracer DAO should seek to avoid seeking a licence that better describes the activity undertaken the users of the smart contracts. If only out of self-interest, seeking a licence that describes a third party’s activity unnecessarily expands Tracer DAO’s scope of liability, an outcome detrimental to its long-term prospects and viability. Seeking to license Tracer DAO may not even make sense from regulatory perspective however, if it serves to obscure the entity actually responsible for the misconduct. Back in 2018, the Financial Services Royal Commission highlighted the dangers of a delegated or dispersed licensing model when it looked into the financial advice sector to examine rogue financial advisors employed under a ‘Corporate Authorised Representative’ operating under a delegated FSL. Not only was it difficult to ascribe the individual misconduct back to the FSL holder (nearly always a business entity whose relationship with the advisor was intermediated by the CAR), regulator powers geared towards punishing the licence holder through fines or revocation resulted in a narrow range of options with which to pursue the individual advisor.

The main takeaway from this is that Tracer DAO should seek to be licensed for functions it can actually control, as opposed to activities it happens to be adjacent to. To be clear, this conclusion doesn’t mean Tracer DAO can wipe its hands of any responsibility for how its smart contracts are used (not least, if it truly aspires to robust regulatory settings): what it does mean is that the checks and balances on how its smart contracts are used will likely need to be developed by Tracer DAO in-house, an area which has yet to be fleshed out in its explanatory details to date.

Market Licence (ML)

Alternatively, Tracer DAO may seek to obtain an AML to operate a market exchange for the financial products that utilise its smart contracts. In my view, this would seem to be the obvious option, as it would capture the majority of Tracer DAO’s functions without encroaching on the activity of the smart contract users, including the:

  • Oracle frameworks (analogous to the tape function provided by conventional markets);
  • A reputation system (essentially a credit rating system);
  • Privacy-preservation and safeguards against front-running: these would typically be built into the operating structure and rules of any modern financial market place.

Holding an ML would place Tracer DAO squarely in the regulators’ sights (and I do mean plural, see below), with plenty of cautionary tales to demonstrate the consequences if Tracer DAO fails to meet the mark: at the time of writing, both Binance and Bitmex have been censured and marginalised by the FCA and the CFTC respectively, for charges related to running an unlicensed crypto-asset marketplace.

Even domestically, designating itself a crypto-asset marketplace would expose Tracer DAO to the RBA, as well as ASIC. More broadly, in light of the recent noises APRA has made as to conducting a post-mortem on Xinja, I’d expect increased scrutiny to be applied to fintech going forward. In short, Tracer DAO needs to have its shit together before applying for an ML.

Clearing and Settlement Licence (CSL)

It’s not clear to me whether this is a relevant option for Tracer DAO: given its smart contracts are self-executing, there shouldn’t be a need for an entity to be licensed for clearing and settlement functions. However, it’s possible that Tracer DAO would require a CSL to validate its role in developing the clearing and settlement functions of the smart contract.

Given that the CSL regime was developed based off the ML, if anything this strengthens the case for Tracer DAO to apply for a ML in the first instance: if the CSL is required, it should be able to leverage off the preparatory work undertaken to apply for the ML, if not apply for them at the same time. Otherwise, the consequences of acquiring a CSL mirror those associated with an ML: a high degree of regulatory scrutiny.


Let me know what you think!

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Seriously awesome write up @Dour_Scotsman, this is awesome work.

Your point here is so important:

Tracer DAO should seek to be licensed for functions it can actually control

The tricky thing for the DAO to manage is that Tracer is a new kind of technology start-up organisation, with the goal of building new solutions that make the old obsolete and in doing so, benefiting everybody.

Complying with regulation means building internal capabilities and perhaps changing or constraining the scope of the organisation to some effect. This cannot come at the cost this organisation’s natural strengths or product differentiation.

Seems like the best approach is being pro-active and collaborating with policymakers as early and often as possible, whether licensing makes sense or not.

It’s in the remit of numerous polly’s to ensure innovation and venture keeps happening in Australia, establishing collaborative initiatives with them is probably key.

The DAO could also consider engaging with Chloe White, she used to run the blockchain roadmap with department of industry and now she’s consulting the Aussie crypto and helping with policy development.

Here’s a quote from her business website:

Genesis Block was born out of the need to provide the crypto-ecosystem with a strategic pathway toward sustainable growth and competitiveness

genesisblock.com.au

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Thanks for the reply, @Agyle! It’s always nice to have someone else in the sandpit to play with.

I’m so glad that you picked up on my point that the licence needs to accurately map onto what Tracer DAO is principally responsible for. A licence that exceeds Tracer DAO’s remit unnecessarily invites the public and regulators to hang more responsibility for eventualities beyond its control.

On the flipside, Tracer DAO really needs to bullet-proof its own internal processes and systems for dealing with third party entities in the Tracer ecosystem. I’d be highly surprised if a future licensing system for crypto-assets didn’t include an obligation to have adequate risk management systems, which feature commonly enough in other licensing regimes for other financial participants. APRA’s prudential guide SPS 530 on how super funds need to monitor their outsourcing arrangements might provide a blueprint for what that might look like for Tracer DAO.

Finally, totally agree on the importance of a future crypto-asset licensing regime not baking in redundancies that aren’t relevant for the Defi space. It’s a different context, but one of the things which caught my attention in ASIC’s consult paper on crypto Exchange Traded Products is the focus with which they’ve paid upon custodians. I understand why they’ve done that, but in a Defi context where linkages are on a peer-to-peer basis the necessity of a custodian should really be on a case by case basis: you wouldn’t want to bake that into the licensing regime, necessarily.

I guess that goes to underscore the importance of having effective communicators to champion the crypto-asset cause to the (parliamentary) laypeople in charge of the crypto-community’s future in Australia. Chloe had a varied background in Government prior to her current role, so she should have the political nous to know how the game is played.

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Hello @Dour_Scotsman

Like @Agyle, I am blown away by your comments and am thankful that you have started this conversation.

The regulatory environment for DAOs and DeFi will evolve dramatically in the years to come, including within Australia. It’s in our interest to remain abreast of these developments, so that:

  1. Actual and potential changes and constraints impacting Tracer DAO, and other DAOs are understood;
  2. Tracer DAO’s community, and other DAO communities can properly inform regulatory developments; and
  3. Tracer DAO, and other DAO communities can continue innovating.

For these reasons, Mycelium has spent quite some time thinking about how regulation might impact DAOs and DeFi. A lot of our thinking aligns with yours. We usually agree with Chloe White too, so would be very interested to hear her thoughts on licensing approaches for DeFi @Agyle.

In the Australian context, our thinking is laid out in submissions to the Senate Select Committee on Australia as a Technology and Financial Centre (https://www.aph.gov.au/sitecore/content/Home/Parliamentary_Business/Committees/Senate/Financial_Technology_and_Regulatory_Technology/AusTechFinCentre/Submissions) and to ASIC (https://ipfs.io/ipfs/QmQwdnRHFYc816S37tLwE4rMBRA5U72yP7nupNJsPxuSGc?filename=21_07_27_CP_343_SubmissionMycelium (1).pdf).

Speaking to the issue of DeFi licencing specifically, we agree that, under current Australian licencing regimes, it is unclear whether, and in what contexts, the various types of entities participating in decentralised systems (ie, DAOs and DeFi) require licences. The types of these entities include:

  1. Software developers: who write code for the decentralised system (or part of the system);
  2. Auditors: who review the code for the decentralised system, to ensure it works as intended and is secure;
  3. Governors: who participate in proposals and votes in order to make changes to the decentralised system;
  4. Token-holders: who hold some rights (governance, economic, utility, etc.) in relation to the decentralised system;
  5. Oracles: who provide data to decentralised systems, allowing them to make decisions or execute transactions;
  6. Graphical user interface (“GUI”) providers: who build, deploy or maintain a GUI (including a website or app) to the decentralised system;
  7. Users: who use the decentralised system (both retail and institutional); and
  8. DAOs: who control, via distributed governance, the decentralised system (including DAO contracts and DeFi protocols).

This assumes that licences are obtainable under current circumstances (which, as you mentioned, does not seem to be the case).

From what we have learned so far, we agree that legislative action is needed. In our view, the preferred progression of DeFi-related legislative action in Australia is as follows:

  1. A safe harbour, or improved sandbox, suitable for DeFi projects (see; https://www.bitsofblocks.io/post/time-for-a-safe-harbor);
  2. A new regulatory framework enabling privacy-preserving KYC methods which are suitable for DeFi (see: https://eprint.iacr.org/2021/907 and https://medium.com/zero-knowledge-validator/introducing-the-zk-open-legal-report-and-working-group-98ff0ae85d8c);
  3. A new, globally standardised, regulatory framework for DAOs as business structures (see: https://medium.com/@mycelium/summary-the-dao-model-law-51fd4febbd4 and https://www.afr.com/companies/financial-services/digital-lawyers-call-for-a-new-legal-entity-the-dao-limited-20210715-p589wp);
  4. A clear taxonomy for tokens under existing or new legislation (ie, to allow for tokens to be included in licence applications); and
  5. A new regulatory/licencing framework with minimum requirements, or voluntary standards, for DeFi (ie, to allow for a DAO to obtain a fit-for-purpose FSL, ML or CSL, or something similar).

Interested to hear your thoughts on some of these ideas.

If you would like to jump on a call, please reach out to jack@mycelium.ventures.

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I agree with you Jack, unless there is some kind of legal personality recognized for a DAO in the first place, licensing as currently envisaged is simply unavailable to any DAO.

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Hi @Dour_Scotsman ,

I enjoyed reading your points and agree that it will benefit Tracer DAO especially in the long run.

However, my concerns would be after acquiring those license, we might have to impose KYC for users and will not be able to operate in a decentralized manner.

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Yeah, I think there is an exodus of users from FTX and Binance to Ddexes because of their recent stand towards regulations and KYC. And I believe this is where Ddexes like Tracer shines. If we were to go ahead with licensing, Tracer will be pressured to implement KYC.

And @LawTalkingGuy brought up a good point. Licensing is not available to any DAO unless there is a legal personality that represents the DAO.

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At Mycelium we certainly take the stance that this financial infrastructure will be regulated at some point (AML/KYC) if it wants to meaningfully reach end users. Where we hope the industry moves and what we believe the most viable solution to be is an identity system that can be integrated at the smart contract level where a user does not have to reveal their identity (beyond a public key) by using zero knowledge proof technology (which validates a user is AML/KYC compliant, without them having to show their identity) and trustless decentralised infrastructure such as Chainlink. This retains a decentralised, open-source contract layer that is immutable and unstoppable whilst individuals that participate are not tied to any form of identity.

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Loving the level of engagement!

To be clear, I absolutely recognise Tracer DAO holding a licence is a non-starter for as long as our regulatory regime fails to imbue DAOs with independent legal personality.

However, and without wanting to sound hackneyed, Voltaire’s quote of the ‘perfect being the enemy of the good’ comes to mind: my 2c is that it’s prudent to think about how Tracer’s constituent stakeholders might pursue licensing under the status quo, as opposed to simply hoping that a legislative solution will present itself within a commercially viable timeframe. If nothing else, such conversation will sharpen Tracer’s thinking on what an improved regime should like (the modern consultant might unironically call this ‘gap analysis’), and Tracer’s stakeholders get a better measure of their potential liability depending on the function they perform.

To my mind, there are 2 ways of thinking about this which are really 2 sides of the same coin: the first is to start with the licence classes currently available, and attribute them to functions performed by various Tracer stakeholders/mechanisms. Alternatively, you could start from the other end by taking stock of all the stakeholders in the Tracer universe and attempt to situate them against the functionally equivalent legal classification. I’ve focussed on the former, but the latter approach seems to be what Jack had in mind based on his pos above (although Jack/Mycelium’s Senate submission seems to note both approaches).

On the AML/KYC front: one of the areas I’d be interested in is what those obligations should look like between crypto-communities, in addition to each community’s individual obligations to report back to the regulator (aka the inter/intra divide). It’s something I haven’t thought about much, but from personal experience I know it’s standard practice for institutional investors to require KYC information from each other: given Tracer DAO’s ongoing conversations as to Treasury diversification (potentially with tokens from other Defi systems), what AML/KYC obligations should look like between crypto-communities would be timely.

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On the issue of licencing - what will happen (in time) is that DAO-appropriate licencing will emerge. Maybe not quickly and probably in a messy process. But it will happen.

We see this in institutional and innovation history. So entrepreneurs engage with institutions in (at least) one of three ways (Abide, Alter, Evade) and there are three types of entrepreneurial types (productive, unproductive, and destructive). Now you’re going to say that classification of entrepreneurship is subjective (and you’d be right).

Right now in the crypto space entrepreneurs are (I think) being productive but those new products can’t fit into existing institutions. So Institutions need to be altered. But policy makers may think that entrepreneurs are being unproductive (why do we really need new-fangled defi when the trad-fi works just fine?) or even destructive AND trying to evade institutions.

So this means the crypto industry has a marketing problem - not just sell product to users, but sell the industry itself to the community, including policy makers.

So yes, in the short run try and retro-fit crypto structures into existing classifications. But in time, we’ll have to engage with policy makers and (a) address their concerns and (b) tell them a positive sum game story about what it is we need.

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It maybe advisable to consider, in the mean time, to show and/ or apply certain core principles that govern FSL requirements: (i) operate a fair, transparent and orderly market (ii) appropriate risk management practices (iii) retail trader complaint handling (iv) business continuity

In looking at the ‘on-line industry’ and their practices that raise a flag with regulators, and we only need to look at Binance and Coinbase and the CFD brokers, through customer complaints, it was that their platforms fell over in critical times and their clients couldnt trade out of their positions, no ability to talk to customer support [bots + price manipulations to run stops

  • so maybe to show how these issues are addressed, is but one important step in the education process we can show the ‘community’ and so, the regulators

Learn from the mistakes of others or never let a disaster go to waste as I think Binance is the Titanic

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This is a very good post, @Dour_Scotsman, thank you for it. I agree with your assessment about the regulatory environment.

I think the core problem is the DAO structure under Australian law - it just falls between the cracks. Without a corporate structure it is very hard to to navigate what would be the appropriate regulatory approach for any particular product or service.

I gave evidence with colleagues to the Senate Select Inquiry on Australia as a Technology & Financial Centre. You can see the appearance (with my colleagues Darcy Allen and Aaron Lane) here from about 10:46 on the recording.

Key thing from Senator Bragg I think is DAOs. While he was a bit negative on setting up new company structures in Australia’s Corporations Act, I think we can see the appetite and a path to do so, albeit a difficult one. As you’ll see, our suggestion is to Australian-ise the COALA approach, and set up some sort of LLC or LL(DAO) model, but obviously we’re still at early days in this process.

In the meantime Tracer still needs to build! So I think the approach being taken is right. The DAO needs to demonstrate a desire and willingness to be subject to appropriate regulatory oversight.

By operating in good faith, in public, and fully engaged in the policy and regulatory discussion, as it is, the DAO should demonstrate to policymakers (not just regulators) that there is a gap in Australian law that needs legislative attention if we are to attract and retain businesses that create prosperity and Australian jobs.

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Hi @chrisberg! Grateful for you and @SincDavidson paying attention to my OP.

I’m going to sound like a broken record, but I really want to stress the amount of time Parliament can spend dithering on whether to introduce a new corporate personality. As a real-life example, in 2009 the Johnson Report recommended a corporate vehicle for collective investment, to attract money from markets unfamiliar with collective investment through a unit trust structure (as is commonly done in Australia and other parts). Treasury only just released its next installment on CCIVs last Friday…

One thing in favour of an accelerated timeframe for legislating DAOs is the model law, which means that policymakers aren’t starting from scratch. One curious absence I noted in the model law however was any mention of how DAO assets would be dealt with on default. Bankruptcy is almost certain to be a key component in a future DAO regime, so I was wondering if anyone might be able to explain its absence from the model DAO law?

On an unrelated note- I also wanted to pick up on a concern you and your colleagues made in relation to ‘Managed Invest Schemes’ that got picked up in the Senate’s 2nd report. It’s an interesting observation, and one I hadn’t thought of yet.

If I go back to to the legislated definition of a MIS, that would captured passive investment pools or property development funds: my view would be it’d be a bit more of a stretch for the legislated MIS definition to capture Tracer DAO on the basis of what it aspires for perform. It does however heighten the importance of a taxonomy of crypto-assets: under the FCA taxonomy, communities built around currency and security tokens would be more suspect to concerns of an unregistered MIS, whereas utility token communities less so.

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Hi everyone, thought I’d join in on the discussion! Great to see lots of big brains in here.

Unfortunately it’s not a huge stretch for TracerDAO to get captured by a MIS classification. While the FCA taxonomy works well to avoid this problem in the UK, it would not necessarily work as well in Australia, as the UK has the benefit of a narrower legal definition of a MIS (in the UK, an interest in a MIS derives a “financial” benefit, whereas in Australia, it merely derives a “benefit” that can amount to “advantage or profit”). ASIC could create a carve-out if they wanted to (and industry has asked them to), but they will get bashed over the head for doing too much in way of setting policy without direction from the Tsr/Tsy. Reform is clearly needed, and we know and expect that Parliament will take a long time to implement it. Hence why the number one ask from Blockchain Australia is for a ‘safe harbour’ or transitional period so that early movers aren’t penalised while they adjust to the new regime. I tweeted about this today:

Happy saturday night, nerds… and regards from lockdown. C

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Hi @chloe ! Glad to see you wading into this conversation.

I see what you mean about the broad/ambiguous ambit for ‘interest’, particularly when contrasted to the UK equivalent. The breadth of the MIS definition has certainly had unintended consequences in the annals of Australian corporate history, where we had to carve out litigation funders from the definition, only to add them back in more recently: the joys of principle-based legislation…

Where I think Tracer DAO stands a little further back from being captured by the MIS definition is the final element that the scheme’s members ‘do not have day‑to‑day control over the operation of the scheme’: In the Tracer context, the responsibilities conferred by the governance token relate to proposals that go to the heart of its functions (software development, financial engineering, market participation). In my view (and it’s one which reasonable minds may disagree on) that places Tracer DAO’s token holders closer to the DAO’s ‘day-to-day’ control, and therefore less likely to fulfill the MIS definition.

More broadly, and my point in the post above is that DAOs offering Utility Tokens requiring some action on the token holders part will bring them closer to being part of its day-to-day operations. DAOs offering currency/security tokens that accommodate their holders to taking a back seat will cling closer towards the definition of the MIS. Given that currency, security and utility tokens aren’t necessarily mutually exclusive, I can see how in future a point in dispute will be the nature of the benefit conferred by the token.

So, In a nutshell: narrowing what constitutes an interest would mean DAOs of all stripes to avoiding falling foul of the prohibition against running an unregistered MIS (if that’s the intention). However, DAOs which require more active participation from their token holders (and I would put Tracer DAO in this bucket) are less likely to meet the current definition of a MIS.

p.s. there’s a really comprehensive discussion on the MIS requirements in the matter of ‘Idyllic Solutions’ [2012] NSWSC 1276, at paras 1390-1415: full disclosure however, it’s dreadful boring.

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Caveat, I have much to learn and not entirely commenting on the substantive discussion, which is fascinating. Also, I’m writing from the U.S.

I’d be careful when founders and/or other exec team members make statements on intents re: law and regs without some protection, i.e. attorney client privilege. In future law suits, including regulatory enforcement, you would hate to see these posts become part of discovery. While you can explain, you would need to explain nonetheless. Perhaps anons and hypos when talking the law and specifics regarding the legality of the product.

Next, on the larger more theoretical question, from someone who has never been intimately involved in production of software, don’t most companies first build an application with market fit/use case in mind, regulations second?

Also, from an attorney perspective, the more closely a product aligns to a product which is already being regulated, the more likely a regulator (or judge) will apply a law to your business/app. Maybe counterintuitive, but the less legal you are, the more likely you’re legal.

Of course funding impacts this approach because investors may want more assurances that your product is legal.

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Lots of ways in which ASIC could interpret “participation” and day to day involvement in operations. Their handling strategy is similar to the sentiments recently expressed by Gary Gensler: to paraphrase, if you are skirting around the edges of the law, you’re likely not in line with its spirit. This is an idea that senior officials at ASIC have pushed publically and repeatedly since the ICO boom. While I agree an argument can be constructed to defend against the MIS classification, it doesn’t mean much in practice when the decision is ultimately one of policy intent and desired outcomes - that is, are DAOs something that the regulator wants to encourage, or not? This question matters more than the letter of the law. So I think the Tracer team are on the right track with the approach they have taken so far - active and good faith engagement in policy discourse is exactly where they should be at this point in the policy cycle.

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Slightly off topic but in the space:
A DEX derivative exchange could be offering a ‘financial product’ , but from a regulatory perspective, whose ‘door do they knock on’ [at least for the foreseeable future this maybe playing out in Australia

Also it may be as important for the exchanges treasury to have a bank account in a safe harbour or crypto friendly ‘state’ as was seen with Binance => debanked

  • I am not sure I heard in any discussion on debanking, but an issue was that the banks were seeing money outflows to the DeFi ‘ecosystem’ = they may like to see some money flow back
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Hey guys, I work for Acuant.com and have been following tracer. I’ve been pushing for DeFi engagement as the Virtual Asset Service Provider (VASP) regulation will likely touch many aspects of crypto, unfortunately. That said, I’d like us to be the trusted partner for defi and help in any way I can. We do compliance via api for major exchanges, custodians and other key elements of crypto. If this sounds like something that could be helpful, feel free to reach me at mmarkham@acuant.com. I’d structure something specific to Tracer so we could ascertain fit before having any major costs. I don’t get a commission here, I’m just passionate about crypto and want to get my company involved with the cutting edge of it while helping great projects